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An Overview of the Financial Services Industry

An Overview of the Financial Services Industry

In Hamlet, Polonius counsels "neither a borrower nor a lender be." I can't attest to how easy that would be in Shakespeare's time, but in the modern world it is nearly impossible. Have a savings account at a bank or a prepaid debit card? You are a lender. Have a credit card, or even a phone or utility bill that you pay at the end of the month? You are a borrower.

The practice of borrowing and lending makes the economy function more effectively. Sometimes a person or company has more resources available than they are able to use at that time. At other times, they have insufficient resources to do what they need to do. Those in the former category can lend their resources to those in the latter category, so that all of the resources are put to their best available use at any given time.

Consider as an example Clara, an 18-year-old aspiring attorney. In order to become an attorney, she must attend college and law school, but she has never worked and thus has no money of her own to pay for the education. Furthermore, immediately after graduating her initial jobs will be at an entry level and she will have additional expenses (such as forming a household) that consume much of the earnings at first. Perhaps at age 40 she begins earning more than she needs to meet her expenses, and continues to do so until she retires at 65. From then until she is perhaps 95 she will have no employment income.

To meet all of her objectives, Clara will need to borrow and lend. First she will need to borrow the money to earn her law degree. Conveniently, we will assume that she has a friend who is a 40-year-old attorney who now has more income than he needs. He lends her the money for her education with the promise that in 20 years (coincidentally about the time he himself is retiring) she will pay him back a fixed monthly amount, perhaps with interest. 20 years later, as Clara is entering her own peak earnings period, she begins paying him back, and also lends money to the next generation of aspiring attorney, who will pay her back when she retires.

It all seems very easy and straightforward. It would work, too, if we assume that each aspiring attorney knows a successful attorney who will lend them the money for education, and if each successful attorney can be assured they will be paid back when they need the money in retirement. Unfortunately, things aren't always that neat and tidy. And thus was born the financial services industry, which can be broken down into financial markets and financial intermediaries.

A financial market is a place where borrowers and lenders can buy and sell securities such as stocks or bonds. For example, there could be a market for bonds backed by student loans. These bonds would have standardized features such as loan qualification requirements. If you have 1,000 borrowers who each need $1,000 and 1,000 lenders willing to provide it, you could in theory match each lender to a single borrower. However, each lender would still face the risk that the borrower they are paired with is eventually unable or unwilling to repay the loan. However, by combining all of the borrowers into a single pool, each lender can effectively lend $1 to each of the 1,000 borrowers. If any borrower fails to repay the loss will be minimal. Although this is still a type of direct finance between the borrowers and lenders, the risk to each party is reduced by the pooled nature of the market itself.

Alternatively, a financial intermediary could form to match borrowers with lenders. The classic example is a bank. The bank could use money people place in savings accounts, and lend it to aspiring students themselves. In this case, the bank bears any risk that students fail to repay, but the lender's savings account pays a lower rate of interest than the bank receives from the student. The difference is the bank's compensation for taking that risk. This type of financial service is called indirect finance, because there is a third party (the intermediary) between the borrowers and the lenders.

There are many more types of markets and intermediaries than are provided in this example, but they all perform a similar function: temporarily transferring resources from people or companies that currently have more than they need to people or companies that currently need more than they have.

If you are interested in a career in the financial services industry and found this article helpful, you might be interested in the CFA Institute Investment Foundations program. The curriculum is available free of charge, and if desired you can demonstrate your mastery by registering for the exam. In fact, Chapter 1, Learning Outcome Statement (LOS) a is "describe the financial services industry." So you are already on your way!

 

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